Why Reality Does Not Support The Recent Rally

Looking at the 3% rally the S&P 500 has staged since last Friday you might be led to believe--if you didn't know any better--that the Fed had announced a new multi-hundred billion dollar QE program last Wednesday and that Mario Draghi had detailed a comprehensive plan to purchase distressed periphery sovereign debt in Europe on Thursday.

Of course, in reality one is hard pressed to find any rational basis for the rally other than Friday's "upbeat" jobs number which, upon close examination, had nothing "upbeat" in it as the headline number obscured the sad fact that part-time employment in July rose by a near record 31,000 while full-time jobs are now back to February levels. More likely, the rally can be attributed to the over $800 billion of new cash circulating through the veins of the financial system thanks to the revival of the Fed repo, dead since December of 2008 and now resuscitated as without new cash

Other than that, it is difficult to justify the voracious appetite for risk as despite Jon Hilsenrath's attempts to spin the situation otherwise, the Fed said absolutely nothing last Wednesday to indicate LSAP was forthcoming. Furthermore, on Thursday Mario Draghi managed only to back himself (and the ECB) further into a corner by specifying the maturity of the bonds he might theoretically purchase thus sparking a "front-run the policymakers" rally in Spanish 2s that has provided a nice excuse for Mariano Rajoy and Mario Monti to dig their heels in even deeper regarding their (un)willingness to cooperate with the EU on finding a viable solution to the debt crisis.

Meanwhile, the bad news hasn't abated one bit. S&P lowered its outlook on Greece to "negative" yesterday citing, among other things, the fact that

...the financially troubled nation will likely need further aid from its international lenders amid a worsening economy and delays implementing harsh austerity measures

S&P also projected that the Greek economy will contract at twice the pace predicted by the IMF over the next two years. S&P also put four Spanish banks on "CreditWatch negative' today as the bailout package for Spanish banks will likely force holders of subordinated debt to absorb losses. Meanwhile, in Italy, the economy contracted .7% in the second quarter, plunging the country deeper into recession even as its Prime Minister Mario Monti insists upon exacerbating tensions with Germany and other eurozone core countries that may well represent its only chance of securing a lifeline.

In the U.S. where, judging by the price of stocks anyway, everything is fine, investors (or banks, or whoever is doing the buying) seems to be conveniently oblivious to two rather disturbing developments. First, no one seems to be worried about the fact that barely a week ago a rogue algorithm nearly caused the collapse of Knight Capital--that's not exactly something that should be judged based on a "all's well that ends well" type of assessment. Second, corporate profits were down in Q2 for the first time (YOY) since the financial crisis, revenue surprises were negative, and analysts now expect EPS to fall by 1.5% in the third quarter.

On top of this, those who point to the fact that earnings have generally surprised to the upside should be reminded that this is only because expectations have been persistently revised downward. From Citi:

...equity analysts tend to revise expectations down while earnings season is still ongoing, which explains why some 72% of S&P500 companies manage to beat expectations in a weak quarter...to get a truer picture of the magnitude of disappointment, it's necessary to freeze estimates prior to the start of earnings season...and viewed this way, we see that earnings surprises have been as bad as the third quarter of 2011, which were impacted by the Japanese earthquake and the debt ceiling

Of course, I don't recall a Tsunami or a debt ceiling debate during the second quarter.

Given all of this, there does not seem to be a compelling argument for a bullish view on the markets at present. It is difficult to imagine how the current situation in Europe could end well and it is even more difficult to imagine how the ongoing crisis could possibly be resolved without having a material negative effect on U.S. equities especially considering how much negativity has been effectively "priced-out" (if you will) of the market as of late. I recommend a short position in the S&P 500 (NYSEARCA:SPY) and a long position in volatility to guard against what I view as a conglomeration of strong headwinds.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.